Saving, Investment, and the Financial System

1. Saving, Investment, and the Financial System Chapter 13

2. Why do we need a financial system? Coordination problem facing savers, on one side, and borrowers, on the other.

3. Financial Securities Legal contracts specifying cash flows.

4. Fixed Income Securities (Bonds) • Corporate • Municipal • Treasury

5. Bond Characteristics • Maturity (or term) • Credit risk • Tax treatment of interest

6. Interest Rates: 10 year Treasury

7. Equities (Stocks) • Represents ownership with limited liability • Key numbers: dividend price-earnings ratio earnings per share

8. Dow Jones Industrial Average

9. Dow Jones Industrial Average

10. Exchanges: Single Location Larger older companies trade on New York Stock Exchange.

11. OTC (over the counter) markets: organized networks of dealers Newer and small companies trade on NASDAQ National Association of Securities Dealers Automated Quotation System

12. Debt (bonds) Fixed cash flows (interest). Principal to be repaid. Default leads to bankruptcy. Equity (stock) Cash flows tied to profits (dividends). No principal to be repaid. Investors are residual claimants.

13. Function of Financial Markets ...

14. Broker-Dealers(Direct Finance) • Sell and buy securities on behalf of clients (brokers) • Sell and buy for firm’s own account (dealers) • Issuing securities for corporations (investment banking)

15. Financial Intermediaries(Indirect Finance) • Depository institutions • Mutual funds

16. Indirect finance characterized by asset transformation • Liquidity transformation • Maturity transformation

17. Saving and Investment

18. In a closed economy saving equals investment Recall: Y= C + I + G + NX Let T be taxes net of transfer payments

19. Different Kinds of Saving Private saving = The portion of households’ income that is not used for consumption or paying taxes = Y – T – C Public saving = Tax revenue less government spending = T – G

20. National Saving National saving = private saving + public saving = (Y – T – C) + (T – G) =Y – C – G = the portion of national income that is not used for consumption or government purchases

21. national saving Saving and Investment In aclosed economy : Y = C + I + G Solve for I: I = Y – C – G = (Y – T – C) + (T – G) Saving = investment in a closed economy

22. Budget Deficits and Surpluses Budget surplus = an excess of tax revenue over government spending = T – G = public saving Budget deficit = a shortfall of tax revenue from government spending = G – T = –(public saving)

24. Deficit versus Debt The deficit is a flow—the amount spending exceeds revenues in a given year. The debt is a stock—the cumulative effect of deficits and surpluses over the years.

25. The U.S. Government Debt • The government finances deficits by borrowing (selling government bonds).

26. WW2 Revolutionary War Civil War WW1 U.S. Government Debt as a Percentage of GDP, 1970–2010 63.6% in 2010

29. http://www.brillig.com/debt_clock/

30. National DEBT to GDP ratios

31. The Market for Loanable Funds Assume: only one financial market All savers deposit their saving in this market. All borrowers take out loans from this market. There is one interest rate, which is both the return to saving and the cost of borrowing.

32. The Market for Loanable Funds The demand for loanable funds comes from investment: • Firms borrow the funds they need to pay for new equipment, factories, etc. • Households borrow the funds they need to purchase new houses.

33. Supply 5% Demand $1,200 The Market for Loanable Funds Interest Rate Loanable Funds 0 (in billions of dollars)

34. S2 1. Tax incentives for 5% saving increase the supply of loanable 4% fund s . . . 2. . . . which reduces the equilibrium interest rat e . . . $1,200 $1,600 3. . . . and raises the equilibrium quantity of loanable funds. An Increase in the Supply of Loanable Funds Interest Supply, S1 Rate Demand Loanable Funds 0 (in billions of dollars)

35. 1. An investment tax credit increases the 6% demand for loanable fund s . . . 2. . . . which raises the D2 equilibrium interest rate . . . $1,400 3. . . . and raises the equilibrium quantity of loanable funds. Investment Incentives Increase the Demand for Loanable Funds Interest Supply Rate 5% Demand, D1 $1,200 Loanable Funds 0 (in billions of dollars)

36. S2 1. A budget deficit 6% decreases the supply of loanable fund s . . . 2. . . . which raises the equilibrium interest rat e . . . $800 3. . . . and reduces the equilibrium quantity of loanable funds. The Effect of a Government Budget Deficit Interest Supply, S1 Rate 5% Demand $1,200 Loanable Funds 0 (in billions of dollars)

37. Use the loanable funds model to analyze the effects of a government budget deficit: Draw the diagram showing the initial equilibrium. Determine which curve shifts when the government runs a budget deficit. Draw the new curve on your diagram. What happens to the equilibrium values of the interest rate and investment?

38. Crowding-out Idea that investment by business will go down if government borrows. Interest rates rise due to competition for loanable funds

39. 10 year Treasury security rate at 1.85%